Cost of Inventory
The term cost of inventory refers to the expenditures associated with merchandise placed in inventory. The categories of costs associated with inventory include manufacturing, product, and period costs.
While companies may use a number of methods to value inventory, the basis for such methods is historical cost.
The cost basis approach is commonly used to value merchandise placed in inventory. Companies have a number of methods they can use to value items held in inventory such as LIFO, Average Cost, FIFO, and Lower of Cost or Market.
The foundation of these methods is historical cost, and the following list contains those categories commonly associated with inventory:
- Manufacturing: includes expenditures associated with raw materials, direct labor and overheads. Inventory costs can include raw materials, work in process as well as finished goods. Overhead costs include indirect labor and materials, depreciation, utilities, rents, and taxes.
- Product: includes the costs associated with bringing the manufactured goods to market. This can include warehousing, handling, purchasing, freight, and other costs incurred until the time of sale.
- Period: FASB rules state companies can capitalize some interest (financing) costs associated with inventory. For example, builders of real estate and other projects that take a considerable amount of time to complete and involve substantial costs. Financing expenses associated with goods that are routinely manufactured cannot be capitalized, and should not be included in the cost of inventory.
When calculating manufacturing costs, companies have the option of choosing between two methods.
- Variable Costs: includes only those costs that vary directly with the volume of goods produced. When using this method, all fixed costs, such as depreciation, are charged as an expense in the current accounting period.
- Fully Allocated Costs: includes both variable as well as fixed costs associated with the manufacturing process. For example, a pro rata share or allocation of costs such as insurance, rents, utilities and other fixed overheads would be assigned to goods placed in inventory.